Two Options for GSEs Get Single Bad Grade

The Government Accountability Office (GAO) entered into the debate over the future of Fannie Mae and Freddie Mac on Thursday, blistering some of the most widely discussed options for revamping the government-sponsored enterprises.

Though the watchdog agency did not take a formal position on what policymakers should do with the enterprises, it essentially declared two ideas unworkable — fully privatizing the GSEs or turning them into public utilities. Those options could spur inefficiencies, raise mortgage rates and take banks out of the business of offering traditional mortgages, the GAO concluded.

The report offered detailed pros and cons of other options including nationalizing Fannie and Freddie, simply restoring the firms to their previous status, breaking them up into multiple entities or turning them into cooperatives.

In the year since the federal government seized the GSEs, options for how to deal with them have multiplied, even though the Obama administration has said it will not deal with the issue until 2010. The 73-page report by the GAO, which undertook the analysis independent from a lawmaker request, could play a critical role in shaping the debate.

While many Republicans and other conservatives have pushed for years to privatize the GSEs or eliminate them, the GAO found only one benefit to such an approach: enhanced market discipline. But the agency warned that it was not clear if privatized GSEs could support the mortgage market during a crisis. The report also indicated it would represent a radical shift to the market, one with potentially harmful consequences.

"Lenders might be less willing to originate 30-year, fixed-rate mortgages, due to the associated interest rate risk of holding them in portfolio," according to the report. "Additionally, privatization or termination could result in a relative increase in mortgage rates, because private sector lenders might not have the funding advantages that the enterprises derived from their federal sponsorship over the years."

The GAO was also critical of a relatively new concept promoted in January by then-Treasury Secretary Henry Paulson: turn the GSEs into public utilities. The report found no benefit to such an approach and cited a serious flaw.

"It is not clear that the public utility model is an appropriate regulatory structure because, unlike natural monopolies such as electric utilities, the enterprises have faced significant competition from other providers of mortgage credit over the years," the report said.

The GAO further noted that the model has been criticized as inefficient, leading many states to deregulate their public utilities.

Some observers said the GAO report could kill that option for good.

"That's probably a good thing," said Thomas Stanton, a fellow at the National Academy of Public Administration, who was consulted by the GAO for this report. "The public utility model basically says these things may get huge but we'll just regulate them and I don't see regulation as an effective solution to that problem. The GSEs were formidable in dominating their safety and soundness regulator and would be just as formidable in dominating a public utility regulator."But by casting doubt on the public utility model and privatization, observers said the GAO appeared to be more enthusiastic about converting Fannie and Freddie into government agencies.

"That seems like the easiest structure to do," said Bose George, a mortgage equity analyst at KBW.

The GAO pointed to several advantages of creating a government agency to care for secondary markets. "A government entity may be able to continue to fund its activities through government debt issuances," according to the report. "In contrast, for-profit entities face conflicts in supporting mortgage finance during stressful economic periods because they also must be concerned about maintaining shareholder value, which may mean substantially reducing their activities or withdrawing from markets entirely."

The GAO still found downsides to creating a government agency, including the possibility that a failure to rein in risks could result in "significant loss" to taxpayers.

While he was still the director of the Federal Housing Finance Agency, which now runs the GSEs, James Lockhart said policymakers should debate the future of mortgage finance broadly first.

"That includes determining the most appropriate roles for private and public sector entities, competition and competitiveness, risks and risk management, cyclicality and the appropriate channels and mechanisms for targeting the underserviced and protecting consumers," Lockhart wrote in an Aug. 19 letter to the GAO.

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